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Global autos: diesel’s demise?

Despite recent scandals, it is too early to call the end of the diesel car.

It is difficult to believe now that cigarettes were once advertised with a message of health. `More Doctors Smoke Camels Than Any Other Cigarette` and `Lucky Strike – Smoke a Lucky to feel Your Level Best` are straplines that supported brands in the 1930s and 1940s in the US. Could future generations be equally incredulous that Volkswagen (VW) once promoted its diesel cars as environmentally friendly? Its “clean diesel” marketing campaigns helped sell half a million diesel cars in the US between 2008 and 20151, with VW claiming in 2009: “Hybrids? They’re so last year2.”

Governments also encouraged motorists to make the switch to diesel for green reasons. The 1997 Kyoto protocol climate change agreement mandated advanced economies to reduce greenhouse gas emissions by five per cent from 1990 levels over 15 years. European Union (EU) countries were expected to cut their emissions by eight per cent3. Reducing CO2 emissions from cars was one of the most practical ways of reaching this goal. However, while Japan and America developed hybrid and electric cars to meet the target, the EU encouraged a shift to diesel. Diesels accounted for more than half of new car sales in Europe by 2010, having steadily gained market share for more than two decades due to tax incentives. While the proportion of diesel sales in Europe has fallen slightly since peaking at 56.1 per cent in 2015, they continue to account for over 50 per cent of overall new car sales, according to Association Auxiliaire de l'Automobile (see Figure 1).

But while diesel engines produce lower emissions of CO2 than petrol engines, they generate larger emissions of carcinogenic particles, such as nitrogen dioxide (NO2); exposure to which causes 23,500 deaths annually in the UK according to the Department for Environment, Food, and Rural Affairs.4

Figure 1: Share of diesel cars in Europe, 1990-2015

Source: Association Auxiliaire de l'Automobile (AAA), 2016

The VW emissions scandal marked a turning point in diesel’s fortunes. The German carmaker admitted in September 2015 to installing secret software in 475,000 diesel cars in the US, which duped exhaust emissions tests to make the engines appear cleaner than they were. In reality, the cars emitted up to 40 times the legally-allowable pollution levels. VW now faces a US$24 billion bill to cover fines, compensation and penalties globally, while sales of diesel have collapsed in the US. Just over 250 diesel cars were sold in the US in January 2017, compared to up to 10,000 a month prior to the diesel scandal5. Sales have also started to reverse in Europe.

Other car companies have been implicated. Germany’s Opel and Mercedes have been forced to recall cars and the German authorities have found "irregularities" in cars from 11 other carmakers: Renault, Alfa Romeo, Chevrolet, Dacia, Fiat, Hyundai, Jaguar, Jeep, Land Rover, Nissan and Suzuki6.

It’s not just `dieselgate` that is undermining sales “A perfect storm has engulfed diesel, which is now seen as harmful to the environment and people’s health at the same time as electric vehicles (EVs) have become more practical, says Alessandro Rovelli, Senior Credit Analyst at Aviva Investors. “Various cities in Europe, including Paris, Madrid and Athens are planning diesel bans by 2025.”

Last orders?

Nonetheless, it is far too early to administer the last rites over diesel. Ed Kevis, European Equities Portfolio Manager at Aviva Investors, believes the transition to alternatives will be gradual. “Diesel is still well established in Europe and has fuel economy advantages over petrol, while the automakers have invested heavily in this sector and will continue to promote diesel and strive for a slow, managed decline.”

Rovelli agrees with this analysis. “There is always a trade-off between governments’ desire to appear green and to protect jobs,” he says. “The rise of EVs suggests job levels in the auto industry will be maintained even as the transition from diesel takes place, but governments do not want to see entire production lines shutting down.”

Meanwhile, Trevor Green, Head of UK Equities at Aviva Investors, highlights the fact that since diesel engines are up to 30 per cent more fuel efficient than petrol engines (an assertion supported by What Car7), and this figure can be materially higher under real-world conditions, they are crucial in achieving fuel efficiency and emissions targets mandated by the US and EU among others.

The European Commission, for example, has mandated that by 2021, average emissions from new cars should be no more than 95 grammes of CO2 per kilometre. The average in 2014 was 123.4 g CO2/km. Green believes this target will be impossible to achieve without a hefty contribution from diesels.8

Kevis also believes carmakers need time to adapt. “Carmakers operate on very thin margins. The question is whether they can sustain their free cash flow, as they increase capital expenditure to drive the transition to new technologies such as EVs and self-driving cars,” he says. “Moreover, the traditional carmakers are competing against new, technology-based entrants with higher free cash-flow margins and higher free cash-flow generating abilities. The latter can afford to invest heavily in new markets such as EVs and open new avenues of revenue and growth. The existing carmakers, by contrast, are also trying to protect their own market share.”

While the share of diesel is set to decline, Rovelli believes it will continue to account for a significant proportion of new car sales in Europe for many years to come given fuel economy advantages and lower greenhouse gas emissions compared to petrol. It may also take years before EVs gain widespread acceptance among the public. Current emissions regulations in the EU are unlikely to be tightened in the near future given the time it takes to co-ordinate any such move. The German, French and Italian government are also likely to be protective of diesel given its importance to their car industries. So even by 2025, diesels could still account for around a third of sales, according to Rovelli.

Rovelli believes automakers with strong balance sheets and a foothold in EVs, self-driving cars and hybrids, such as BMW, Daimler and VW are best placed to manage the transition away from diesel. He also believes Renault is well placed but is less optimistic about Groupe PSA, which owns the Peugeot and Citroen marques, and is vulnerable given that diesel accounts for around 40 per cent of its sales, a higher proportion than for other major manufacturers.

Automotive suppliers that are geared towards niche parts of the European diesel sector could actually fare well in the aftermath of the Volkswagen scandal, according to Green. He cites Johnson Matthey, a company that supplies catalytic converters for diesel engines, as a prime candidate.

Green points out sales in Johnson Matthey’s diesel dominated European Light Duty vehicles division have spiked recently. “The pace of volume growth in this division is quite telling and it could be explained by car companies deciding they should work towards being compliant with the existing legislation,” he says.

Meanwhile, Rovelli believes Delphi, Continental, and Valeo should do well given their exposure to other areas such as in-car entertainment. Critically, Delphi and Continental supply the new 48-Volt electrical systems, which could replace the 12-Volt technology used in cars today. The 48V systems have a number of advantages including reducing emissions and boosting fuel efficiency significantly.

“48V could have a significant impact on earnings at Delphi and Continental and ease the transition out of diesel into lower emission technologies,” says Rovelli.

On December 21 the people of Catalonia go to the polls to elect a new regional government. There is a lot riding on the outcome, not just for Spain’s political system, but for the country’s economy and financial markets too.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 1 March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0298/30062017

The following investment professionals contributed to this article

Alessandro Rovelli

Senior Credit Research Analyst

Main responsibilities

Alessandro is responsible for conducting credit analysis on global credit portfolios, with a specific focus on global commodities.

Experience and qualifications

Alessandro joined Aviva Investors from Deutsche Bank where he was a portfolio manager in the Loan Exposure Management Group. Prior to Deutsche Bank he worked with UBS as a research analyst. In his time at UBS his team was ranked number 1 by Institutional Investor for their specialised research report publications containing fundamental, relative value and trading ideas for bond issuers in the Telecoms sector.
Alessandro has an MBA in Analytical Finance and Accounting from the University of Chicago, Booth School of Business.

Trevor Green

Head of UK Equities

Main responsibilities

Trevor manages institutional and retail UK equity funds.

Experience and qualifications

He previously worked as a fund manager at Henderson Global Investors, where he was co-manager of the Henderson Managed Distribution Fund and provided equity input into the Henderson World Wide Income Fund. Prior to this, Trevor worked at New Star Asset Management and before that spent nearly six years at RCM. He has also worked at Credit Suisse Asset Management and started his career at Capel Cure Myers.
Trevor holds a BA Honours degree from Aberdeen University

Edward Kevis

Fund Manager, European Equities

Main responsibilities

Ed is the fund manager of Aviva Investors’ European Equity Income funds. His responsibilities include supporting the day to day running of all other European Equity funds run out of London office. Ed’s specialism is in the Support Services sector.

Experience and qualifications

Ed progressed to his current role in 2015 after working as the assistant fund manager for European Equities, and was initially hired as a support services equity analyst for the European and UK Equity team.
Ed began his career with Lloyds Banking Group, initially joining the Business Specialist Scheme with various roles in corporate lending, strategy and risk management in the Wholesale Banking division, and then moving to the Business Support Unit Investments team, initially in the Portfolio team but later moving to a combined transaction and portfolio role.
Ed holds a BA (Hons) in Finance Accounting and Management from the University of Nottingham, and an Applied Diploma in Corporate Banking. He has also passed Level 1 of the IMC and is a CFA charterholder.